Factor Investing For Dummies
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Factor investing can help you build a portfolio designed for your unique risk tolerance, investment time horizon, and financial goals using characteristics that history shows lead to consistent outperformance.

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An investment time period is the timeframe you expect to hold an investment, usually short (less than five years), intermediate (five to ten years), or long term (more than 10 years).

Factor investing provides a building block that gives you the best odds of reaching retirement and income goals successfully. It helps improve portfolio results and reduces volatility. Factor investing, done right, enhances diversification in a way that lowers risk without sacrificing returns, by placing your investment eggs in many baskets to help ensure positive results!

Following a systematic approach

In a nutshell, factor investing is about defining and following a set of proven guard rails that keep your portfolio on track. Using a factor strategy not only gives you better returns, but delivers them more consistently while also protecting you from the dangerous pitfalls and mistakes that get other investors in trouble.

Leveraging the power of a persistent strategy

Investors worldwide have always sought the secrets that would help them invest right alongside legendary investors like John Templeton, Warren Buffett, Jesse Livermore, Benjamin Graham, and John “Jack” Bogle.

Investing systems and rules have come and gone over the years, because it turns out many of them worked only in specific markets and just for a few years. These strategies picked up on short-lived trends and rules in stocks that were true only for a limited time due to certain conditions unlikely to repeat.

When you’re investing based on factors, you’re interested in a persistent strategy — one that can deliver results in the future.

By figuring out the themes, characteristics, and properties common to winning investment, or factors, you can discover a set of rules to create higher-performing portfolios.

But how do you even try to comb through the mountains of market data over the last 100-plus years to find what works?

Well, it turns out that you’re in luck! In the last few years, financial academics have been hard at work doing just that — distilling these factors into useful sets of rules that you can put to work in your portfolios today.

Though nothing works 100 percent of the time, especially over shorter periods, factors are most effective when combined with other factors in a master strategy. This has the effect of loading the dice in your favor.

Saving time with factor investing

Time is money, the old saying goes, and investors since the ancient Chinese rice traders have always looked for ways to save time by streamlining and systematizing their trading and investing decision processes.

We all have busy lives, jobs to get to, kids to take to after school sports, and a million other things. A factor investing strategy can help improve your life by helping you make best use of your time and energy.

James used factor investing to save time during the COVID-19 market bottom in March of 2020. He needed an approach that identified resilient stocks and funds most likely to benefit from a market rebound, while also giving clients confidence in the historical reliability of these stocks to survive and thrive the unprecedented economic and market downturn everyone was experiencing as the world rapidly went into social distancing, quarantines, and government-mandated shutdowns.

He came up with a multifactor portfolio for new clients using the same principles in this book that was both sophisticated and easy to understand. This strategy gave them the confidence to enter the depressed stock market and stay on board for what turned out to be a profitable 18 months for investing, with many portfolios doubling in value.

Using modern advances

As investors, you always want to look for ways to take advantage of advances and breakthroughs in the investment field. Two trends that have come together to move investing forward have been computers and history; specifically, better methods of market data analysis and greatly expanded historical datasets to feed those computers.

Modern computers and new ways of crunching market data are at the forefront of the growing interest and advances in factor investing. Just as important is the expanding dataset as researchers and archivists have combed through old ticker tapes, micro-fiche and ledgers to complete the historical dataset of stock prices and company data; in some cases, right back to the Buttonwood Agreement that pre-dated Wall Street.

What is the Buttonwood Agreement? It’s a single-page document that started the New York Stock Exchange 230 years ago on May 17, 1792, when 24 merchants and brokers met under a buttonwood tree and put their signatures to a set of rules and safeguards for trading. The meeting was necessary to re-establish public confidence in markets after the infamous Financial Panic of 1792 that had caused mayhem earlier that spring.

Investing options were limited back then. The only stock available was in the Bank of New York, The First Bank of the United States, some insurance companies, and Revolutionary War Bonds issued by Alexander Hamilton to help pay off the War of Independence from British rule.

Today, you can also take advantage of databases, services, and perhaps even pre-packaged investment products such as funds and ETFs that attempt to apply factor methodology in a practical way to select investments based on current stock and bond metrics.

Luckily, technology has made factor investing far easier and more cost effective than ever, as we detail in later chapters.

This enhanced dataset provides a richer and more complete testing ground to ferret out meaningful factors and to test existing assumptions more fully. This is an advance that you can benefit from!

Following proven guidelines that work

Even a broken clock is right twice a day, and, like a coin toss, any system can come up with a winner or two from time to time. As an extreme example, a rules-based system (factor) that consisted of “sell all U.S. stocks and buy bonds” may have worked very well as a factor from September 1929 until July 1932, but this was only due to the stock market crash that kicked off the Great Depression.

Using this factor after 1932 would have been a recipe for disaster and decades of underperformance! The point here is that you’re looking for guidelines that provide a more universal advantage, and are not dependent on a specific set of historical circumstances.

The best factors you’re interested in work in many different markets, countries, and decades. They aren't just one-trick ponies that have shown results once or twice in history, perhaps by chance or due to unique circumstances. You want rules that operate more broadly and dependably.

Following a disciplined core strategy

The most successful investors have a disciplined strategy driving their success. Incorporating factors into your investing adds not just a methodology for investment selection but also discipline to portfolio activity as it helps you determine what to buy, sell, or hold, and gives you the confidence needed to participate in the long term.

Protecting against emotional investing

The emerging field of behavioral finance says that regardless of how you design your portfolio, the major reason for your success or failure is your emotion-driven actions. In other words, if you want to be successful at investing, you have to protect against emotional investing, which results in buying high and selling low, repeatedly.

The long-running DALBAR study, which has been updated annually since the inception of the 401(k) over four decades ago, proves that this problem is widespread and damaging to wealth building. Investors lack discipline (of course it's not you, just other investors).

What is DALBAR? Located in Boston, DALBAR is one of the nation's leading independent research firms committed to raising the standards of excellence in the financial services industry. It compiles and analyzes mountains of data on mutual funds, life insurance, and banking products and practices. It has also been behind the nation's leading study on investor behavior for the past 28 years.

One of its most followed publications is the annual Quantitative Analysis of Investor Behavior (QUIB) Report, which measures how investors have performed with their actual investment portfolios versus how the funds they hold have performed during the same periods.

You might think that investor performance and fund performance are the same thing, but DALBAR consistently demonstrates a devastating investor performance gap due to investors shifting money among their investments (for example, from stock into more conservative bonds or cashing out at exactly the wrong times).

Compounded over the years, this performance gap is devastating, costing many investors literally hundreds of thousands — or even more — in retirement dollars they could have enjoyed.

For example, its 2021 study shows that this performance gap jumped to a shocking 1032 basis points for 2021. 100 basis points equals one percent, so this represents a lag of 10 percent for investors versus the performance of the average fund they were investing in.

Obviously, despite the recovery from the 2020 COVID-19 market lows, many investors bailed (perhaps believing the recovery was too good to be true) and then got back in at higher prices in the fall, only to experience a downtrend and realize they had once again bought high without benefiting from the previous gains.

In short, DALBAR's extensive research shows that investors are their own worst enemies. The results, as shown in the chart below, are sobering and hard to dismiss as the researchers used real-time data from millions of investor-directed 401(k) accounts. DALBAR has concluded that as much as two-thirds of the market return investors should have enjoyed were squandered to emotional investing — selling into fear after downturns, and buying into euphoria after upturns.

The problem, of course, is that investors end up bailing near the bottom, when they've had enough pain, and buying again near the top of the market cycle, when they can't stand to miss out anymore. These mistakes get compounded over the years, and become even more damaging.

The results are similar in every annual update of the DALBAR study. In short, it turns out that most investors are doing exactly the opposite of what they need to do to build wealth. They are buying high and selling low.

A factor-based approach helps you avoid becoming an emotional investor. A portfolio strategy based on factors (ideally a diversified combination of multiple factors) can provide discipline, and powerful protection against emotional investing by offering a portfolio with which an investor can feel confident riding through inevitable downturns on the way to new highs.

Only historically persistent factors can provide this sort of assurance, enabling investors to achieve their financial goals and helping to make sure their emotions don't cause them to outlive their assets.

About This Article

This article is from the book:

About the book authors:

James Maendel, BFA, AAMS, AIF, DACFP, founded Maendel Wealth, an investment advisory firm. He has won the Five Star Wealth Management award for multiple years. Paul Mladjenovic is a national speaker, educator, author of Stock Investing For Dummies, Currency Trading For Dummies and other Dummies titles and runs RavingCapitalist.com.

James Maendel, BFA, AAMS, AIF, DACFP, founded Maendel Wealth, an investment advisory firm. He has won the Five Star Wealth Management award for multiple years. Paul Mladjenovic is a national speaker, educator, author of Stock Investing For Dummies, Currency Trading For Dummies and other Dummies titles and runs RavingCapitalist.com.

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